How regulators can benefit from a focus on risk: Harvard’s Malcolm Sparrow

The public’s demands on regulators are growing and a shift to risk-based regulation and the recognition of the importance of skilled “regulatory craftsmanship” can help them meet these demands, says Harvard Professor Malcolm Sparrow.

Professor Sparrow leads ANZSOG’s Managing Regulation, Enforcement and Compliance workshops, including a recent five-day course in Cairns, the first time ANZSOG has offered the course in regional Australia.

“The public at large seems now to expect more of government in terms of anticipating harm and threats. Even with natural disasters – governments are expected to be better at anticipating, much more creative at mitigating, and much more effective in responding to save lives and property,” he said.

“In Australia there is a very strong shift towards risk-based regulation, and part of what I do in my workshops is to help regulators explore all the various versions of risk-based regulation and the implications of adopting a risk-based strategy.”

Professor Sparrow said risk-based regulation had lots of different meanings for different people and situations, but at its core was the idea of acting to minimise risks or harms rather than relying on the assumption that existing functional programs and good process-management will necessarily take care of them all.

“The problems of the real world come in awkward shapes and sizes which often have no natural home within the existing structure of regulatory bureaucracies. So, regulators need the fluidity to be able to organise themselves around specific risks, and to do so without sacrificing their established expertise in functional areas or damaging the performance of their core processes,” he said.

“That’s not to downplay functional expertise, nor the importance of process management. Processes, once established, are inescapable. If you don’t keep up with the process load, and deal with it accurately and reliably, these things will blow up in your face and become a visible embarrassment.

“When we talk about risk-based regulation – we are not trying to replace these processes, we are trying to complement them, and to integrate the capacity to deal effectively with risks into organisations which have already mastered other kinds of work.

“It is an ongoing challenge and something that many organisations in Australia are trying to do. This has proved a surprisingly difficult task.  Progress made in developing a risk-based or problem-centric capacity often turns out to be fragile when – for instance – key personnel or champions move on, executive leadership changes, or political winds of change blow through.”

The regulatory pendulum and regulatory craftsmanship

One of the issues that afflicts regulation is the “swinging of the regulatory pendulum”, as governments switch from adversarial enforcement-centred strategy to more trusting and cooperative postures, and then swing back again when something awful happens.

The danger of regulatory capture is particularly acute when regulators adopt a mindset that the industry they regulate is their “customer” and lose sight of their mission to protect the public at large.

Professor Sparrow said that the development of a genuine “regulatory craftsmanship” should permanently eliminate the swinging of the regulatory pendulum.

“Regulatory craftsmanship means being the master of all your tools and knowing how to organise them around a specific task.  Almost no task has a single-tool solution, so—like any competent carpenter—a skillful regulator knows how to use them in combination and sequence to get the job done.”

He said regulatory craftsmanship was a simple idea, but that it was often quite difficult to identify who, within regulatory organisations, was actually expected or authorised to exercise it.

“The opportunity for craftsmanship sits mostly within the ranks of middle management –  because they are senior enough to have the authority to deploy multiple regulatory tools, but are closer to problems and can work faster to deal with them than an executive team which is appropriately focused on longer-term strategy and capacity development.

“I ask agencies: who is it, exactly, within your organisation that exercises regulatory craftsmanship? It can often be a challenging question for them to answer,” he said.

He sees regulatory craftsmanship—and clearly recognising all the forms of discretion that it involves– as an important way of improving regulatory effectiveness.

“In general, removing people’s discretion or clamping down on it tends to result in utter stupidity. When you see obvious examples of regulatory stupidity, it is often because a person’s discretion has already been taken away, giving them no choice but to follow standard procedures in situations that turn out to be quite non-standard.

“Respecting regulators expertise and examining how they used their judgment in complex situations is a more appropriate form of accountability than: have you followed the rules?

Keeping regulators’ discretion: why the banking Royal Commission made the right call

Professor Sparrow has worked with the Australian Securities and Investment Commission, an organisation which has come under heavy criticism for its failure to act against widespread malfeasance in the banking industry.

He says that the Haynes Royal Commission into the finance industry made the right decision in not calling for major changes to ASIC, nor placing specific restrictions on what it could do.

“Clearly there was a concern that ASIC had not been prepared to take serious criminal enforcement action when it might well have been warranted, and I understand that concern because the core calculus should be that crime does not pay.  The prospect of serious criminal sanctions should prey on the mind of anyone perpetuating fraud against consumers,” he said.

“But in my view, the Haynes Report was notable for what it did not do. It did not recommend breaking up ASIC or removing its right to use civil penalties rather than criminal, or reducing or restricting ASIC’s role, scope, or discretion.

“While there was pressure to change ASIC’s “enforcement culture”, the commission did not establish any new rules or favour one approach over another. Overall, they did not recommend any major changes. Instead they effectively said: please adjust your prior probabilities, so you’ll be more likely to take serious enforcement action, even again major institutions, when they engage in criminal fraud.

“If the agency is listening, and I’m quite sure ASIC has been listening very carefully, then this is sufficient. They will obviously be closely scrutinised over the next few years to see if they have made appropriate adjustments in their use of the full regulatory toolkit.”

Weighing the costs and benefits of technology

Professor Sparrow, asked about the rise of big data and artificial intelligence, commented that these would obviously create new opportunities for regulators, and new decisions for society to make around the balance between personal privacy and regulatory efficiency.

“Artificial intelligence and pattern recognition can help regulators to spot emerging trends and anomalies, to anticipate trouble more effectively than in the past. These methods can serve to make regulators more vigilant,” he said.

“However, a lot of this – including all the things associated with ‘smart cities’ – involves monitoring techniques in one way or another, and I don’t think we are in a position to fully understand the costs and benefits of these yet.”

He noted the United Kingdom’s widespread use of CCTV, which was used extensively in the investigation of the 2005 London Underground bombings, to track the movements of the perpetrators through public spaces and the transport system.

“Things get more complicated if we add facial recognition software and license plate recognition to create vast databases of people movements on a routine basis. What if we do that proactively to identify suspicious behavior? The ethics of that, and the privacy concerns, and who might get access to that data and under what circumstances—these things have not been entirely thought through.”

Professor Sparrow’s workshops bring people together from at least 20 different regulatory areas, many of whom are grappling with the same underlying regulatory issues, albeit with different vocabularies.

He said that regulatory decisions were always complex and involved a degree of conflict, because they involve careful balancing of non-aligned interests, and one party or another has to take some loss for the sake of a bigger broader public good.

“There is always inherent conflict in regulatory roles.  If, on whatever issue you’re dealing with, there were a solution available that would make all stakeholders perfectly happy, then the chances are that this issue doesn’t really need regulation. The market could find an optimal solution,” he said.

Professor Sparrow said the vibrant discussion about regulatory systems in Australia and New Zealand was “delightful”.

“This is definitely something which does not happen to the same extent in most other countries. It is delightful from my point of view that you all recognise these issues as important, and worthy of serious examination.”

Want to hear more? Professor Malcolm Sparrow will lead ANZSOG’s Managing regulation, enforcement and compliance regulation, enforcement and compliance workshop in Canberra in October, and The modern regulator in Sydney in November. Find out more at the Workshop page.